04: Brains, Gray-Hair or Efficiency

28
Jan

Steve Preda discusses three types of professional service firms in terms of their organizational structures, pricing structures, and overhead. He then describes how these factors interact to produce varying degrees of profitability and scalability.

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Brains, Gray Hairs and Efficiency One

Today I’d like to talk about a concept that I picked up from David Meister who wrote the seminal Managing the Professional Services Firm, actually Managing the Professional Service Firm, many years ago and he introduced this concept to me that keeps my brain spinning and since which in which he speaks about different types of professional services firms. He says that generally they fall into one of three types. There are firms that he refers to as the brains firms, there are gray hair firms, and there are the efficiency firms. So what does it look like and what differentiates these different firms?

So the brain firms are the ones that have a handful of highly paid experts. These are really cutting edge people with cutting edge knowledge of their business, and they essentially selling themselves. They’re selling their knowledge, they’re selling their consulting, and they charge by the hour. Typically, these people will have premium prices. So think about maybe a criminal attorney who is top-notch at saving mafiosi, or think about a doctor who is at the top of their profession, or think about maybe an accountant who is specialized in vintage cars or something that is really unique, maybe venture capital, something that is unique and they have a special knowledge of, or maybe taxation, maybe it’s about offshore taxation, whatever it is. So these are the brain firms.

Now a brain firm, what it looks like, typical brain firms maybe have two or three partners, maybe a little bit more, and then just a couple of secretaries, or maybe a paralegal, just to serve and do some research for them, but essentially they come to the office, they sell their hours, and they go home, and they make a very high margin on their services because the overhead is very light. So that’s the brains firm. The second type of firm is what Maister calls the gray hairs firm. So think here about maybe a family law firm or maybe a corporate run of the mill corporate law firm that serves small to medium sized businesses and these people would come to the law firm and what they expect?

They don’t expect cutting edge advice. What they want is someone who knows their stuff, who’s not going to screw up the case, who will give them a pat on the back, basically make them comfortable and reassure them that they are in good hands, everything’s going to be okay and they’re not going to lose their livelihood, they’re not going to have a bad divorce that’s going to be hunted down by the IRS. So that’s the service that they’re looking for. They want the gray-haired professional with lots of experience, who will personally hold their hand and make sure that they are okay.

In professional services, there are brain firms with cutting-edge expertise, gray hair firms for seasoned assurance, and efficiency firms for streamlined success. Click To Tweet

Now, what does a firm like this look like? It could be basically, it’s top-heavy in terms of senior people, whether they are partners or just paid employees. So in a typical firm, you would have maybe a few partners, maybe three or four partners, and then you have some senior employees who are not partners because they’re not good at finding their own clients, but they are great at delivering the service. And then maybe you have some junior staff who will, you know, again, paralegals who will do some digging for them.

But essentially, it’s either the partners are making their own money and a little bit of a cut on the junior people or they are making their own money and they make a cut on the senior people who are not partners because they cannot kill their own beast. And that’s it basically. So it’s a little bit more leverage than the brains firm but not that much more. But the third group is the efficiency firms. Efficiency firms basically have the pyramid, the classic professional services firm pyramid structure.

So think about a big four where you’ve got a bunch of analysts or they call them actually assistant auditors. They come in the first year and they just, they’re smart people but they don’t have a clue about auditing or they are not CPAs, they go through the training and they just do all the busy work, it needs good thinking, it needs intelligent people because it’s not all manual anymore. But essentially, people who will just muddle through and follow the processes and the work for the more senior people. So you have then the audit seniors and then you have the managers, senior managers and the partner.

So there is a pass to partnership, it takes anywhere between 9-15 years typically, and it’s an up and out system. If you don’t make the next level, you’re going to be encouraged to leave the firm. At the top of the pyramid sit the partners who are essentially making the money on all the levels below them, and essentially leveraging for the cheap labor, cheaper intelligent labor to get the business done. So this could be an accountant firm, it could be a management consultant firm. So think about McKinsey and Company, same thing, pyramid structure, up and out.

You’ve got a bunch of really intelligent, smart, but inexperienced kids who have great ideas and they just follow the process, they work 16 hours a day, and as they go up the pyramid, some of them will become partners and they’re going to make half a million, a million dollars a year, leveraging all that relatively cheap labor. I mean, McKinsey’s premium price, so no one’s complaining, even the youngsters get paid well, but it’s still a leverage structure.

In the professional pyramid, intelligence rises from the base, where young minds fuel the process-driven ascent. Partners at the top reap the benefits, transforming cheap labor into lucrative business outcomes. Click To Tweet

Now, in terms of these firms, so what does it look like in terms of profitability in the short term and in the long term? And what does it look like when you want to sell on this firm? So let me go through that. So profit, short-term profitability. So it’s easy to see that the brain firms provided that they have a name, the partners have a name already and people are seeking them out. They open shop, they sell their hours, low overhead. So immediately from day one, they are profitable. And and it’s basically a high profit, low risk business to be in a brainless firm in the short term.

And second most profitable is, I believe, the Greyhound firm, because in the short term, again, you’ve got the partners, they’re going to be doing the work, then they’re going to groom some senior employees, maybe they bring them up, they’re going to take a cut off the top of the senior employees but they already know their staff because they have a lot of experience so not much babysitting required and then you have a couple of paralegals at the bottom who are going to help as well.

Now because these people are employing people so their overhead is going to be higher than the brain firm overhead but it’s gonna be basically up and running from day one, not much business building required. So it’s gonna be fairly profitable. So I would say number two in profitability short term is the gray hairs. Number three is the efficiency, because the efficiency firm is all about building the mass, the muscle mass, the bottom levels. You can only leverage those people if you have a way of attracting good people, it’s going to take some time.

When I was running my own investment banking firm, it was an efficiency operation, just by virtue of I wanted to start a partnership, but no one wanted to partner with me in the early days. And when I got things going, I didn’t want to bring on a partner because I felt like I was doing all the work, I’d done most of the heavy lifting already, so it didn’t make sense to bring on a partner. So it ended up being an efficiency firm, but it took me several years, probably four or five years before I got good quality employees.

The first round, I just, you know, employed whoever was willing to work for an unproven firm, which was my firm, and then some of those people left, and then I managed to get better people as my firm started gaining reputation. And it was probably more even than five, it was five, seven years. By the time I was getting the top of the crop, the best people in town, they came to us, some of the best people, not all of them. So it was a long investment, and all the while I was paying salaries, I was building out my office, I was making mistakes.

So it was very unprofitable at the beginning, but over time it became more profitable, but it was a long run. So in the short term, I would say efficiency firm is definitely the least profitable firm. Now what about the long term? What does this look like in the long term? So the picture there is different. In the long term, I would say the efficiency firm has the most profit potential. So, you know, when you have built up your reputation, you build a brand, you have a bunch of good people, then you just have to get there to feed them with work and they’re going to make money for you.

So long term, definitely efficiency firm. I’m going to look at McKinsey and Company or the other management consulting firms, look at the big four. They are all very, very profitable. Second most profitable is the brains firm, I believe, because the brains firm has so little overhead, it’s very resilient. If there is a recession, people will still go to the best people in the business for advice. So the brains firms will always have clients. They will not have overhead, so in lean times, they can just sell fewer of their hours or maybe cut a little bit prices, but essentially they’re going to be profitable in bedtimes and good.

Thirdly, the gray hair firms, because they will not be seen as the premium provider. They are employing people, but they are not leveraging them so much. So in the long-term, the upside for gray hair firm is fairly limited. The downside is fairly substantial. So the long-term, the gray hair will be the least profitable. Now what about viability? So what about the intention and desire for outside parties to buy these firms? I believe that the efficiency firm, again, comes out on top. It’s going to be the most viable. Why? Because there’s no risk of losing the value of the firm because it’s not depending on the brains of the company. It’s depending on a good culture that attracts talents. It depends on good processes. It depends on the strong brand.

Gray hair firms have a wealth of experience and expertise in their respective fields. Clients often seek their services for the assurance that comes with dealing with seasoned professionals. Click To Tweet

So if the owners phase out, the firm can still be very variable. Number two is the gray hair because the gray hair will have something to sell, because it’s not just the partners, there will be other senior employees, provided they have enough runway beyond the sale. If you have a bunch of partners in their 60s, and all their friends are the senior employees who are also in their 60s, then you’re screwed. Your firm is gonna be not very sellable, because you have a generational problem there.

But if you have, if you’re straddling the generations, you’ve got some senior people in their 50s, in their 40s, in their 30s, then it’s an eminently sellable firm, can be plugged into another firm and our partners can retire and the firm with its clientele can be taken over. Now, what about the brains firm? I believe the brains firm will have trouble selling because its partners cannot sell themselves, they want to retire, and since they represent almost all the value in the firm, if they stop being active, then the firm is worth nothing.

Sometimes the way you sell this firm is you try to bring on some other brands people, younger people, and you make a deal with them, you allow them to buy themselves in over time, and then whoever is the buyer, they have to believe that the young people will be able to take the bet on from you. But again, the young people might go and set up on their own and there’s nothing to sell. So it’s highly risky transition and I see brains firms being very hard to sell.

So the three types of firms, you’ve got the brains firms, the gray hair and the efficiency. Brains are people who are top experts selling their own time, with very limited support, so high profit in the short term, but not much scalability in there. Gray hairs, some partners, mix of partners and senior employees. So there’s some leverage on senior employees, but essentially it’s all about a lot of gray hairs, a lot of experience. It’s not about being cutting edge, it’s about being seasoned and providing the comfort to clients that you’re gonna take care of them.

A few junior staff to leverage, but more leverageable than brands. And efficiency is pyramid structure, one or a combination of multiple partners, and a lot more, like 80% of the staff is going to be mid-level and low-level staff. You’re going to leverage those people. I think as you build a good culture and you build a brand, this is going to be in the long term a very profitable asset for you. It’s going to be viable, it’s going to be, you can sell it, you can find buyers who want to buy it and you’re building an asset.

So what do you want to do? What is your firm like? Give me some comments, I’d love to have questions, comments because it’s a topic that I’m very passionate about. I would love to hear from you. So that was it for today. This is Steve Preda. This show is courtesy of Traction Equity. So if you would like to learn more, feel free to check out tractionequity.com. I’ve got a couple of books that I wrote about my investment banking years, which you can download by clicking on the link. to you very soon. to you very soon.Have a great day!

 

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